Apple is a Screaming Buy around $530
Anindya is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The share price of Apple (NASDAQ: AAPL), the Cupertino based tech-giant, created an all-time high of $705.07 on September 21 this year before it started tumbling and trading below the 200-Day Simple Moving Average. For long-term investors the 200-Day Simple Moving Average acts as a very important demarcation line. A stock trading below this line is generally considered undergoing a bear phase. The million-dollar question that’s haunting many long-term investors right now is if Apple’s stock has peaked. In this article I’ll share why I think strong value has emerged in the stock at the current price level around $530 and a sharp bounce back is just around the corner.
Apple’s iPhone 5 Continues to Impress Investors
Apple is expected to sell more than 250 million iPhone 5's over the next 18 months with more than 600 million global smartphone subscribers coming out of their contracts over the next 15 months. Most wireless subscribers coming out of a mobile phone contract look to upgrade their mobile phones. Despite facing tough competition from Samsung’s Galaxy S III and Nokia’s Lumia, Apple’s iPhone 5 is still considered the best smartphone money can buy. Apple is expected to capture a large piece of this particular segment of the market.
The iPhone 5 is equipped with a special chip that supports LTE (long-term evolution) technology. This special chip also supports China Mobile's 3G network and China Mobile has more than 700 million wireless subscribers. I’m not saying every one of these subscribers can afford an iPhone. However, if Apple can capture just 10% of this market, Apple’s iPhone sales would jump 60% just from China demand alone.
The iPad Mini is a Grand Success
Apple launched their latest tablet, the 7 inch iPad Mini, in October. Microsoft (NASDAQ: MSFT), the arch-rival, also introduced their first ever hardware device, the Surface RT, a tablet that runs on the latest version of Microsoft’s flagship operating system Windows RT. But the lack of a broad range of games, tools and other downloadable software will detract Surface in a head-to-head comparison against the iPad and its plethora of more than 275,000 apps.
Apple has played it smart to wait for the 7 inch tablet market to mature and define itself. The iPad Mini sales are expected to score in the forthcoming holiday buying season, leaving Amazon’s Kindle Fire HD, Google’s Nexus 7 and others far behind. Apple has delivered, after just six months, an iPad with 4th generation technology!
Where’s Value in Apple’s Stock?
Apple has been generating economic value for its shareholders for quite some time. I expect the company's return on invested capital (excluding goodwill) to double during the next two years. The new product rollouts should propel Apple's fundamentals even higher. Fundamentally it would be impossible for Apple not to grow its earnings by at least 20% annually over the next two years.
The most appropriate measure of a company’s ability to create value is its economic profit spread, the gap between ROIC (return on invested capital) and WACC (weighted average cost of capital).
A company's economic profit spread (also known as economic value added or EVA) is a measure of its ability to make money on its investments. If the cost of capital exceeds the return on invested capital, the company is losing money. The idea is that value is created when the return on the company's economic capital employed is greater than the cost of that capital.
Apple's 3-year historical return on invested capital (without goodwill) is 280%, which is well above the estimate of its cost of capital of 11%. A 280% ROIC means that the company generated $2.80 of economic earnings for every dollar of capital put into the business over its life. In other words, Apple generated enough cash flow to pay off its original investors 2.8 times in one year.
The scatter diagram shows a regression analysis of how much changes in ROIC explain changes in the ratio of a company's enterprise value to its invested capital. The diagram represents ROIC on enterprise value to invested capital ratios (with an r-square of 76%) for the 492 companies in the S&P 500. This explains why ROIC justifies about 76% of the valuation of stocks in the S&P 500. According to this analysis, Apple's stock is fairly valued for its extraordinary ROIC, at a minimum. However, this regression analysis ignores growth potential. The economic profit spread indicates that the stock is currently trading in a deep value zone with an estimated P/E multiple of just 11 for 09/2013. (Sources: New Constructs, LLC and company filings)
Apple's free cash flow generation (free cash flow divided by total revenue) is quite strong at an average of 25% for the past 3 years. Given the company’s reputation to innovate and impress customers, the strong cash position should be considered as an added advantage to facilitate extraordinary spending in R&D. The iTV is expected to be introduced sometime in the next 12 months. The late Steve Jobs said this would be Apple's next revolutionary product.
To Buy or Sell?
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Anindya12 holds shares of Apple and Microsoft in his long-term portfolio. The Motley Fool owns shares of Apple and Microsoft. Motley Fool newsletter services recommend Apple and Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.